Friday, February 19, 2010

Death of the Washington Consensus?

The IMF last week issued a staff position report (warning: pdf link) that represents something of a mea culpa and a retreat from the Washington Consensus. Taken from the conclusion:

“The crisis was not triggered primarily by macroeconomic policy. But it has exposed flaws in the precrisis policy framework, forced policymakers to explore new policies during the crisis, and forces us to think about the architecture of postcrisis macroeconomic policy.

In many ways, the general policy framework should remain the same. The ultimate goals should be to achieve a stable output gap and stable inflation. But the crisis has made clear that policymakers have to watch many targets, including the composition of output, the behavior of asset prices, and the leverage of different agents. It has also made clear that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way. The combination of traditional monetary policy and regulation tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes. These need to be explored further.

Finally, the crisis has also reinforced lessons that we were always aware of, but with greater experience now internalize more strongly. Low public debt in good times creates room to act forcefully when needed. Good plumbing, in terms of prudential regulation, and transparent data in the monetary, financial, and fiscal areas are critical to our economic system functioning well. Capitalizing on the experience of the crisis, our job will be not only to come up with creative policy innovations, but also to help make the case with the public at large for the difficult but necessary adjustment and reforms that stem from those lessons.”

Nothing controversial about any of the above, but the devil is in the details. There are some pretty conventional prescriptions that the paper advocates – providing banking system liquidity as needed, fiscal prudence during good times, and strengthening automatic stabilisers aka transfers (tax-rebates, handouts) to the poor; but how about these bombshells:

  1.  Should the Inflation Target Be Raised? - “Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?”
  2. Combining Monetary and Regulatory Policy - “If leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be introduced and, if needed, increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be increased.”
  3. Inflation Targeting and Foreign Exchange Intervention - “Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function. This does not imply that inflation targeting should be abandoned. Indeed, at least in the short term, imperfect capital mobility endows central banks with a second instrument in the form of reserve accumulation and sterilized intervention. This tool can help control the external target while domestic objectives are left to the policy rate.”


In case you’re not clear about what they’re talking about, in plain English the IMF are calling for:

  1. A higher average inflation rate target and by extension, a higher than average policy interest rate as well. The basic goal of central banks worldwide in the last thirty or so years has been price stability, which in real-world terms (taking into account structural issues and a buffer for real money supply growth) has translated into an average inflation goal of around 2%. Higher inflation would have distortive effects on business and personal decisions, such as on investment and savings.
  2. Capital controls and market intervention. Can I say, we told you so?
  3. Exchange rate intervention. Can I say…oh, I said that already.

In short, this is a retreat from the free market fundamentalism that has characterised IMF and World Bank policy approaches for decades. What a comedown. There’s also the unspoken acknowledgement here that every country is different, and that the one-size-fits-all approach (or in business-school-speak – using “best practices”) to remedial policies is suboptimal, er, won’t work.

I’m not knocking the basic conclusion that free markets are the best method of organising economic activity. But I do think we have to be pragmatic and recognise that real-world markets everywhere are distorted by asymmetric information and differing levels of pricing power between buyers and sellers. It should also be recognised that while the price discovery process through the interaction of supply and demand is the best way to obtain a Pareto-optimal allocation, nothing says that any given equilibrium point is “first-best”.

Technical notes:

  1. “Rethinking Macroeconomic Policy”, Blancard, O. and Giovanni Dell’Ariccia and Paolo Mauro, IMF Staff Position Note, SPN/10/03, International Monetary Fund
  2. INTERVIEW WITH OLIVIER BLANCHARD, “IMF Explores Contours of Future Macroeconomic Policy”, IMF Survey Magazine

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